8/19/2010 @ 6:05PM

California's Cap-and-Trade Decisions

While the prospects for federal climate policy have been buffeted by political headwinds recently, California is moving forward: The state is in the last stages of developing regulations to bring its greenhouse gas (GHG) emissions back down to 1990 levels. California’s climate target was established back in 2006, but the details of regulatory decisions now being made could significantly impact its business and the economy. Moreover, these decisions could have even broader implications to the extent that California’s policies serve as a test run for other states or the federal government.

California’s GHG emission regulator–the Air Resources Board or “ARB”–recently began to reveal its thinking on the design of the cap-and-trade system, the key element in the suite of more than 30 policies aimed at achieving the state’s climate goal. The basic elements of cap-and-trade have become familiar to most of us: total GHG emissions are capped and firms are allowed to trade the limited quantity of emission permits. Cap-and-trade can help achieve emission reductions with the lowest impact on the economy, but the devil is in the details–the design of cap-and-trade systems can have significant consequences for the policy’s economic consequences.

Among the key issues ARB is addressing are plans to distribute the tradeable GHG permits. The Board’s decisions have significant financial consequences, since the aggregate value of these permits could exceed $30 billion annually, depending on market prices.

Most relevant for business, ARB has indicated that it will use a portion of the allowances to offset the regulatory burden faced by industries most affected by the cap-and-trade policy because of their high energy use and/or greater competition in import and export markets. By freely allocating allowances to these so-called “energy intensive, trade exposed” industries, regulators hope to avoid the “leakage” of both emissions and economic activity to regions outside of California.

However, details in the rules governing how permits will be distributed are still under development, and the outcome may have transformative effects on many businesses. These details will determine whether businesses are eligible to receive free permits, how many they (and their competitors) will receive, and for how long they will receive them. They will also decide whether businesses are net sellers or buyers of permits and how well they can compete with in-state and out-of-state competitors, and they may affect the strong incentives created by cap-and-trade to increase operational efficiency and energy use that may lead to changes in the most effective business models.

As another indication of where it may be heading, ARB recently displayed openness to policies aimed at reducing the risk of “unacceptably high costs.” These so-called “cost containment” policies would allow ARB to achieve a better balance between the costs and benefits of environmental policies. ARB appears to be leaning toward maintaining an extra “reserve” of permits that could be drawn upon in the event that prices become too high. What remains to be seen is whether it is willing to fill (and replenish) the reserve sufficiently to mitigate prolonged periods of high prices and whether ARB will fill the reserve through means that further increase the policy’s stringency and expected costs. By affecting the policy’s costs and the risk of high permit prices, ARB’s decisions will have direct impact on the financial risks faced by carbon-intensive businesses in the state.

While the timing and shape of national climate policy has remained somewhat uncertain, California regulators are making concrete decisions with near-term financial implications. The economic consequences of climate policy are now front-and-center in federal policy decisions, meaning that California’s choices will likely influence the future of these efforts. Despite broad consensus among economists and policy analysts that market-based policies–such as a cap-and-trade system–are essential to achieving meaningful GHG emission reductions, many political decision-makers don’t support their use. A failure by California regulators to carefully design its cap-and-trade system could result in adverse outcomes that would diminish federal lawmakers’ willingness to use similar approaches. That chain of events would be sadly reminiscent of the state-level experience in restructured electricity markets, when a meltdown in California’s wholesale and retail markets effectively terminated further electric industry restructuring in other states. Such an outcome would forestall the economic transformation needed to effectively address the global climate problem.

­­­­­­­­­­­­­­­­­­­Todd Schatzki, Ph.D., is a vice president at Analysis Group, an economic consulting firm that provides business strategy, policymaking guidance, and litigation support to leading firms in the energy sector and in other industries. He can be reached at tschatzhi@analysisgroup.com.